Were Fed’s active monetary policy actions necessary?

Abstract

This work applies the two-stage Factor Augmented Vector Autoregression (FAVAR) developed by Bernanke, Boivin and Eliasz (2005) to investigate the appropriateness of frequent monetary policy actions that involve frequent adjustments of the policy interest rate in a prolonged manner. From time to time there are claims that the Federal Reverse Bank cut or raised the fed funds rate too frequently. This raises the concern that the Federal Reserve Bank mistakenly cut interest rate for too long and too frequently and then paused too short and raised rate again to “undo” the previous unnecessary interest rate cut or vice versa. To verify if such a claim is valid, we generate hypothetical scenarios assuming that the Federal Reserve Bank had shortened the time period of active monetary policies and lengthened the period of a pause. Then, we compare economic activities implied by impulse response functions from hypothetical scenarios with those generated from actual fed policies under the record of Alan Greenspan (1987-2006). We find that a less active monetary policy approach could control inflation with less negative impact on real economic activities, and major economic variables would be less volatile in a 48-month horizon. The investigation provides insights on the implementation of monetary policies not only for the U.S., but also for all central banks that control interest rates as their major monetary policy tool.